April 2005

Consistency, Consensus Needed on Industry Profits

April 2005

by Lt. Gen. Lawrence P. Farrell, Jr., USAF (Ret)

At a time when defense programs are under growing pressure to control costs and increase efficiency, it is important for the industry to be attuned not only to customers' needs but also to the way government officials view contractors' profits.

Although there is a widespread perception that defense contracts yield healthy profits, in reality, the way government officials view profits can be drastically different from the way industry measures that profit.

First, let's review the basics. Firm fixed-price profit levels can be whatever the awarded contract cost structure calls for. By law, a typical "cost-plus," fixed fee research-and-development contract caps industry profits at 15 percent of the cost of the project. Some are limited to 10 percent.

But no matter how the profit margin is determined, industry and government see the margin differently. In one example cited by Jack Cash, a professor of business management at the Defense Acquisition University, a project with costs estimated at $9 million might come with a $1.35 million profit fee, or 15 percent. The same contract, as described by industry accountants, only shows a profit margin of 6.53 percent, rather than 15 percent. The difference is attributed to unallowable costs the industry must pay (such as interest on loans, advertising and bad debt expense) and income taxes. These take a huge bite out of the profit margin.

Government officials generally don't see profit the way it's looked at in the commercial world, Cash points out. "The average person working in a program office doesn't see it." While the policy is structured to pay a reasonable profit, the perception in government circles is that contractors are making far more than what they are.

Under new policy guidance issued by the Defense Department less than two years ago, contracting officers are being asked to change the way they negotiate profits with industry, and are emphasizing areas that traditionally did not factor into contractor profits.

Unlike previous practices, the government no longer rewards contractors for investing in facilities or equipment. As a matter of fact, the government wants to discourage industry from spending money on facilities, and wants, instead, to increase the focus on technical innovation and efficiency, notes Cash. In the past, he says, it used to be that the government wanted to motivate contractors to invest in manufacturing plants and buildings.

The new method for determining fair profits takes into account the level of technical complexity in a program, and whether a company is providing true innovation. During negotiations, a contracting officer will ask questions such as: Is the company pushing the state of the art? Is it buying things off the shelf? How complex is the job to manage, to control costs? What is the company doing technically that hasn't been done before?

This approach marks a drastic departure from the way business has been done thus far. The Defense Department, clearly, wants to ensure that its money is spent wisely. One of the objectives of this approach is to secure a fair profit margin for the contractor. "The government's profit policy is very sound," says Cash.

Things like innovation, however, are hard to quantify. According to Cash, it becomes a judgment call. A company, in fact, could convince the government to boost the profit margin if it can demonstrate innovation.

Cost-efficiency is another new factor now coming into play. If a company can show it can save the government money, the reward could be a higher profit margin, also to be negotiated.

These so-called "weighted guidelines," can work to the benefit of the contractor. Companies negotiating a contract always should fill out the Defense Department Form 1547, "Record of Weighted Guidelines Application," before entering negotiations. Another technique that the government recently introduced is "performance-based payments," as opposed to guaranteed progress payments, which cover the contractor's costs.

Under the performance-based approach, the government and contractor stipulate that a company will be compensated based on meeting specific objectives, rather than with guaranteed payments. The benefit to the contractor is that these performance-based payments can reach up to 90 percent of the program costs, compared to 80 percent for progress payments. That can make a big difference in the contractor's cash flow.

Another potentially exciting reason to move to the performance-based payments is the opportunity to expand the defense contracting market to commercial suppliers. With progress payments, only companies that have defense-unique accounting systems can bid for contracts. Now, commercial firms can bid on contracts, because the performance-based approach does not require those accounting systems.

These are, obviously, complex issues that will require much study and analysis on the part of industry and government. Contracting officials, particularly, will need to learn how industry measures profits and how contracts can be negotiated so that both parties win.

One issue potentially of great concern to NDIA members, however, is the government's new policy to discourage investment in facilities and equipment. Although that would make sense from a cost-efficiency standpoint, it has the potential to undermine our nation’s manufacturing capabilities. With that in mind, the defense industry needs a structured approach to managing facilities, so that critical capabilities can be preserved, without saddling the government with huge overhead costs.

Other observations are worth noting. First, not all program managers use the "weighted guidelines," even though it is the methodology that the government recommends. Secondly, even when the guidelines are used, a maximum margin is available to the contractor of approximately 20 percent. When this is applied to the standard income statement (and accounting for unallowable expenses), the contractor will be lucky to achieve even half of that. Finally, even though the law allows a 15 percent profit on cost-plus contracts, we see some major programs imposing arbitrary limits below that.

We need to continue to emphasize that the defense industry competes in the capital and human resource markets with all firms, including the commercial sector. For the viability of the industry in the long term, we need a fair and a competitive return for defense firms.